Financial crises mainly result from financial liberalisation and exponential credit ex- pansion. The credit bubble is eventually offset by a negative bubble triggered by a weighty drop in asset values, leading to a complete halt in the financial market and to the collapse of several market players (Kaminsky and Reinhart,1999). In the majority of cases, policy responses are initiated in order to aid the functioning of the market and avoid further crashes. As it has been broadly agreed in the literature, the main factors contributing to the development of the financial crisis of 2007-08 are excess liquidity combined with the lack of regulation, as well as the inability of regulators and analysts to prevent such events (Allen et al.,2009;Ayadi,2013).
The Committee on Banking Regulations and Supervisory Practices was set up in 1974 by the central bank governors of the G10 economies11in the wake of market turbulence which followed the collapse of the Bretton Woods exchage rate system. The purpose was to achieve improved financial stability with the cooperative banking supervision of its members. Later the name of the committee was changed to Basel Committee on Banking Supervision. At the time of publication the membership has been extended to 28 jurisdictions (BIS,2014a).
11
The 10 countries that comprise the group are UK, France, Belgium, Germany, Italy, the Netherlands, Sweden, Japan, USA and Canada.
Chapter 2 Literature Review 25
The Basel I accord was agreed in 1988, and it worked towards establishing a collective measure of capital adequacy. The capital measurement system was referred to as the Basel Capital Accord (BIS,2014a). The capital to risk-weighted assets ratio was set to have the floor of 8%, and was implemented in 1992 not only by the member countries, but by all banks acting on the international market. The accord went through several amendments during the years in order to address the enhancement in the measurement of capital adequacy (inclusion of general loan-loss reserves, for example) and market risk (allowing banks to use internal measures such as the Value at Risk, for example). However, the accord was unsuccessful in consolidating the banking system’s capital base.
Ayadi(2013, p.403-404) argues that the accord failed to acclimatize to progress made in the financial system while encouraging pernicious market behaviour. The author sums up his main arguments, noting that:
The use of broad-based risk buckets without taking account of relative risk, the focus on a single credit risk indicator, outdated treatments of securi- tisation and trading book risks, the zero-risk weight, short-term stand-by credits, and the cap on the counterparty-risk weight for swaps, and forward contracts spawned an army of financial engineers and encouraged many of the imprudent practices that are being ruthlessly exposed by an extreme reassessment of credit counterparty risk.
More than a decade later, in 1999 the Basel II Accord was drafted with the goal of addressing the shortcomings of its predecessor. The accord was believed to be “an evolutionary and flexible approach to banking regulation and supervision, which would reflect the rapid progress and sophistication of banking practices and risk management techniques, including securitisation”, asAyadi(2013, p.404) notes. The Revised Capital Framework with its three pillars was released in June 2004. With the aim of continu- ously consolidating the financial system, in September 2008 the Committee issued the ‘Principles for sound liquidity risk management and supervision’ (BIS,2014a), however the principles failed to address the fundamental issues of the market turmoil of 2007-08.
The third accord, namely Basel III, was proposed in the wake of the financial turmoil of 2007-08 and endorsed by its members in July 2010. The Bank for International Settlements’ decree aims to:
improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source; improve risk management and governance; strengthen banks’ transparency and disclosures (BIS,2014b).
26 Chapter 2 Literature Review
bank-level, or microprudential regulation, which will help raise the resilience of individual banking institutions to periods of stress; macroprudential, sys- tem wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time (BIS,2014b).
In 2013, further reforms were introduced, such as the revised Liquidity Coverage Ratio12. The new accord prescribes the number of high quality liquid assets - which at the minimum - should equal the total net cash outflows. Ideally, financial institutions should maintain this ratio on an ongoing basis, at minimum of 100% level for at least a 30-day period, and specifically when there is an iminent threat of financial illiquidity in the market. In reality however, institutions have the prime goal to utilize their assets at the maximum, and consequently to keep the Liquidity Coverage Ratio at the minimum required level.
In essence, there are several shortcomings of the Basel Accords. They do not address market failures such as contagion, neither they encourage emerging economies to back and adhere to international standard principles and regulations. However, some of the emerging economies might not see the rationale for implementing such regulations for they might not be exposed to the mounting level of complexity that characterises the developed financial markets. Moreover, the accords do not clarify what the fundamen- tal anomalies are, and why certain imposed guidelines are best when confronted with liquidity crises and subsequent contagion. Allen et al. (2009) question whether policies and guidlines centered on accounting capital and liquidity ratios are sufficient. The mechanisms to prevent crises are not complete unless measures and policies to prevent illiquidity contagion are in place. The dynamics of contagion are well documented and understood, yet there isn’t an operational model capable of signaling and predicting liquidity spillovers from one market to another.